Growth or the Gap? Which Measure of Economic Activity Should be Targeted in Interest Rate Rules?∗

What measure of economic activity, if any, should be targeted in simple interest rate rules? This paper analyzes the welfare consequences of responding to the growth rate of output and the output gap in policy rules in a conventional New Keynesian model. In spite of the fact that it shows up directly in the approximate welfare criterion of the simplest version of the model, responding to the theoretical output gap, even if perfectly observed, never has large benefits and can significantly reduce welfare if the central bank is faced with a non-trivial gap/inflation tradeoff resulting from time-varying price or wage markups. In contrast, responding to the growth rate of output, which is putatively easier to observe than the gap, is often welfareimproving. These conclusions about the relative merits of responding to growth or the gap also obtain in a medium scale version of the model with both price and wage stickiness, capital accumulation, and different real adjustment frictions. ∗I am grateful to Ruediger Bachmann, Olivier Coibion, Yuriy Gorodnichenko, Robert Lester, and seminar participants at Notre Dame, the University of Quebec at Montreal, North Carolina State University, and the Texas Monetary Conference for many helpful comments which have substantially improved the paper.